Economics: GM- The First Domino to Fall?
New York: March 28, 2005
By John R. Stephenson

"What's good for GM is good for America." - Charlie Wilson, Chairman, General Motors Corporation (Senate hearings 1955)

There is no doubt that General Motors isn't the company that it was during the 1940's and 1950's, but the events of the last week should be a wake-up call for all investors. Over the past week, General Motors slashed its earnings estimates in half. The result? The stock has taken a tumble and the various bond-rating agencies are contemplating downgrading GM's debt to junk. Are the problems at GM unique or do they signal something more troubling about the economy and the stock market in general?

For many, the latest travails of General Motors are dismissed as a non-event. The decline has been coming for some time. Detroit, once the mighty engine of America's economic power, is but a mere shadow of itself, employing just 0.8% of all workers. Nor is American manufacturing what it used to be - down from 33% in 1960 to just 13% of the nonfarm payrolls. Perhaps it is not a surprise that GM got into trouble. After all, they manufacture a product that consumes gasoline and is generally bought on credit making the company particularly sensitive to upward movements in both interest rates and oil prices. But one question remains - is the fall of GM an isolated incident or is it the first domino to fall?

For my money, the troubles at GM might just be the first domino to fall. In large part, the troubles at GM only serve to highlight the broader decline in the U.S. manufacturing sector. So far, the manufacturing sector has born the brunt of a savings-short America that is doing little, if anything, to invest in its future. The combined savings rate of American businesses, corporations and government is at a record low of just 1.5%. With little or no domestic saving and investing going on, America is dependent on foreign governments to continue to support our prolific spending habits.

This savings shortfall was highlighted once again with the release of the fourth quarter 2004 current account deficit (exports less imports). The number was a staggering 6.3% of GDP. With the current account deficit clocking in at around $750 billion on an annualized basis, America is dependent on capital inflows (savings from abroad) of some $2.9 billion per day just to keep the party going. These capital flows are the result of a conscious decision by foreign governments to buy market share (and increase their dollar denominated foreign exchange reserves) for their goods and services. With a declining dollar and the coffers of Asian central banks stuffed to the gills with declining U.S. dollars, one wonders how long the magic can continue?

The week that GM slashed its earnings was also a week of record current account deficits and record short-term oil prices. While oil prices may be shy of their inflation-adjusted peak of a few decades back, the recent move to $56/barrel represents a near quadrupling of oil prices from the lows of 1998. While rising oil prices are a problem for consumers around the world, this problem is more acute in the U.S. than elsewhere because we are much more reliant on the consumer than are the economies of other nations. As well, oil is priced in U.S. dollars and in a declining dollar environment, the impact on the American consumer is more dramatic than it is on consumers in other countries. While the popular press is quick to downplay the importance of oil, the truth is that there is just no substitute for oil and while its importance may be somewhat diminished in an information age, we are by no means immune to a sustained rise in oil prices.

Figure 1: Crude Oil Prices

Source: M. Murenbeeld and Asssociates

Over the last few months, various Asian governments have started to signal that they are tiring of holding massive U.S. dollar denominated foreign exchange reserves. The most recent country to do so was the government of South Korea. While the official policy was quickly recanted (after the U.S. dollar went into freefall), there can be no doubt that their willingness to act as our financiers may be waning. While a reduction in exports or the appreciation of their currency against the U.S. dollar may be a short-term negative for these Asian economies, this needs to be weighed against the costs of continually taking a hit to their investment portfolios by holding low returning declining dollar assets.

Rising oil prices, a declining dollar, problems on the trade and investment front and a profit warning from industrial America all signal possible trouble ahead for investors in U.S. stock markets. Not only that, but the U.S. is extending its military and geopolitical reach at precisely the same time that its economy is weakening. History has shown that great powers often fail once military spending starts to overshadow a country's economic base.

Is General Motors the first domino to fall? Maybe not. But the last couple of weeks have seen some worrisome signs for our economy. Perhaps the folks in Washington have woken up to the dangers that face us and are taking corrective action. Perhaps not. I believe it is always better to be safe rather than sorry. Investors looking to ride out a potential storm should consider dividend-paying stocks, avoiding the homebuilders and financials (interest rate sensitive sectors) and should look to commodities which tend to zig when the market zags.

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